The Wall Street Journal’s Primer on Capital Gains Taxation

One of the principles of good tax policy and fundamental tax reform is that there should be no double taxation of income that is saved and invested. Such a policy promotes current consumption at the expense of future consumption, which is simply an econo-geek way of saying that it penalizes capital formation.

The current Democratic obsession with raising the capital gains tax comes from a mistaken belief that the preferential rate applied to the sale of a family business, farm or financial asset is a “loophole” that mainly benefits the rich.

They offer three reasons why this view is wrong, starting with a basic inequity in the tax code.

Far from being a loophole, the low tax rate applied to capital gains is beneficial and fair for several reasons. First, under current tax rules, all gains from investments are fully taxed, but all losses are not fully deductible. This asymmetry is a disincentive to take risks. A lower tax rate helps to compensate for not being able to write-off capital losses.

Next, the editors highlight the unfairness of not letting investors take inflation into account when calculating capital gains. As explained in this video, this can lead to tax rates of more than 100 percent on real gains.

Second, capital gains aren’t adjusted for inflation, so the gains from a dollar invested in an enterprise over a long period of time are partly real and partly inflationary. It’s therefore possible for investors to pay a tax on “gains” that are illusory, which is another reason for the lower tax rate.

This may not seem like an important issue today, but just wait ’til Bernanke gets to QE24 and assets are rising in value solely because of inflation.

Third, since the U.S. also taxes businesses on profits when they are earned, the tax on the sale of a stock or a business is a double tax on the income of that business. When you buy a stock, its valuation is the discounted present value of the earnings. The main reason to tax capital investment at low rates is to encourage saving and investment. If someone buys a car or a yacht or a vacation, they don’t pay extra federal income tax. But if they save those dollars and invest them in the family business or in stock, wham, they are smacked with another round of tax.

There’s also good research to back up this theory – some produced by prominent leftists.

Many economists believe that the economically optimal tax on capital gains is zero. Mr. Obama’s first chief economic adviser, Larry Summers, wrote in the American Economic Review in 1981 that the elimination of capital income taxation “would have very substantial economic effects” and “might raise steady-state output by as much as 18 percent, and consumption by 16 percent.”

Summers is talking about more than just the capital gains tax, so his estimate is best viewed as the type of growth that might be possible with a flat tax that eliminated all double taxation.

Nobel laureate Robert Lucas also thinks that such a reform would have large beneficial effects.

Almost all economists agree—or at least used to agree—that keeping taxes low on investment is critical to economic growth, rising wages and job creation. A study by Nobel laureate Robert Lucas estimates that if the U.S. eliminated its capital gains and dividend taxes (which Mr. Obama also wants to increase), the capital stock of American plant and equipment would be twice as large. Over time this would grow the economy by trillions of dollars.

P.S. Some of you may be wondering why I didn’t make a Laffer Curve argument for a lower capital gains tax. The main reason is because I have no interest in maximizing revenue for the government. I simply want good policy, which is why the rate should be zero.

P.P.S. I also didn’t bother to make a competitiveness argument, mostly because the WSJ’s editorial didn’t focus on that subtopic. But check out this post to see how Obama’s policy is putting America at a significant disadvantage.

Can’t you make the same points about income tax though? Labor is also a capital good, it’s human capital. It seems unfair to tax gains from labor but not from capital. That’s why a pure consumption tax seems fairest to me, though I understand Dan’s reasoning why that would be politically more difficult.

Such a policy promotes current consumption at the expense of future consumption, which is simply an econo-geek way of saying that it penalizes capital formation.

I think you got that backwards. I’m pretty sure “it penalizes capital formation” is the econo-geek way of saying “it promotes current consumption at the expens of future consumption,” since only econo-geeks understand the jargon used in the phrase “capital formation”, whereas most people know the words used in the longer phrase.

“This may not seem like an important issue today, but just wait ’til Bernanke gets to QE24 and assets are rising in value solely because of inflation.”

Is it true that assets will be rising in value? The asset values will remain fundamentally the same, but their prices will be stated in currency units of less value, giving only the illusion of higher value and new wealth. Those asset prices that can rise in response to declining currency values only tend to protect the owner from the effects. This protection does not alone create new wealth but increased demand for such assets might if one takes the bid at the right time (a big if).

It is the biggest ripoff of all in the IRC that declining currency value results in tax liability. There is no gain at all in such circumstances. That our central bank is pursuing illusion as policy is another subject that should be of great concern. And, if only the financial press would report any “new high” in inflation adjusted terms every time, even using funny government numbers about inflation, more folks might see through.

It seems to be a hallmark of libertarian economic analysis to rely solely on theoretical models. I agree with your Econ 102 analysis, but please, please, please show some empirical evidence that capital gains rates at the range they exist today drive investment decisions, and most importantly long term growth. Because at first blush, a simple historical plot of capital gains rate vs. growth rate shows almost no relationship, and we just finished a decade of both the lowest growth and lowest capital gains rate on record. It seems very possible, even probable, that the wealthy today simply don’t respond to capital gains rates in the 18-30% range.

Reminds me a little bit of a less absurd version of the Laffer curve. Theoretically possible, but not applicable in America today.

bmore: Let us consider those of us that might wish to become wealthy and try for the moment to put the class warfare / envy stuff to rest. High non-indexed capital gains rates impede my attempts to increase my wealth – and due to illusory inflation only so-called gains actually take wealth from me – each time I am required to move to relatively higher producing assets or perhaps more responsive assets in this highly manipulated politicized economy.

jamesbbkk – Not to be a jerk, but did you read my post at all? I believe you just responded to my request for less theory and more empirical support with a thought experiment.

We all understand the idea behind lower capital gains rates. It’s very simple. Finding evidence that it works in practice is more difficult.

There’s plenty of literature on this, but simple historical review suggests the effect isn’t that large. We had massive growth in the post-war era during ridiculously high rates of both income and capital tax rates. We had better growth under Clinton Era rates than under the lower Bush era rates. Etc etc etc. The point is not that lower capital gains have no effect. It’s that the effect, at least at current rates, might be small enough to be completely drowned out by larger macroeconomic trends.

If that’s the case, we might get better use out of that money to paying down the deficit, building roads, or educating our children. That leads to growth as well. Are you really so sure the capital gain effect is larger?

Dan, you say wait until “wait ’til Bernanke gets to QE24 and assets are rising in value solely because of inflation.”

But do assets rise in value because of inflation? Isn’t it instead the worth of each piece of paper (the currency bills) which falls because the government has printed more of them. Do the assets’ value increase, or is it the number of depreciated currency bills in which their value is denominated which increases?

Other things being equal, increase the supply of such pieces of paper and the value of each one falls….

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[…] effects, particularly once the economy has a chance to adjust in response to better policy. So a lower capital gains tax or a repeal of the death tax, to cite a couple of examples, might increase revenue in the long run. […]